A History of the Federal Reserve, Volume 2 (51 page)

The quarrel over bills-only, and its outcome, suggests some of the complexity attached to “independence.” Independence in the 1950s was much different than in the 1920s. Congress held frequent, at times lengthy, oversight hearings at which Martin and others explained and defended decisions and actions. Rumors or evidence of differences between the New York bank and the Board was a call to action by congressional committees followed by a request for Martin, other FOMC members, and outsiders to explain and comment. The Federal Reserve learned that congressional oversight had become, and was likely to remain, a significant means for interested members of Congress to exert much greater political pressure than in the early years. Equally, Federal Reserve statements at public hearings became a more important means of presenting the Federal Reserve’s interpretations and positions to Congress and the public, opening the System to criticism but providing information to the interested public and removing some of the earlier secrecy.

Relations with the administration changed also. Gone was the reluctance to question or influence the Federal Reserve, best represented by the apology for asking advice in President Hoover’s letters to the Board, when the financial system was under intense strain in February 1933. Commitment to the Employment Act meant to many that monetary and fiscal policy should be coordinated. To Keynesian economists at that time, coordination meant that the Federal Reserve should keep interest rates unchanged to permit fiscal policy actions to have their full effect. The precise meaning of coordination was rarely made clear, but the idea resonated with politicians and some of their advisers.
³⁴⁷
Martin did not oppose coordination, but tried to limit its scope. In keeping with his responsibility, he placed greater weight on price stability. But neither he nor his staff considered how to reconcile independence and coordination with the government’s
fiscal operations. To insulate the Board and the FOMC, Martin acted as a buffer by meeting with the president or his agents, keeping other members informed but avoidin
g pressure on them.

347. “He [Martin] carried out those responsibilities always on the basis of open discussion and conference with the Council, with the President, and with Treasury. I know of no time when there was any feeling that our interests were in conflict here. True, you could have differences in judgment. . . . Now, do you need common goals? Well, I have testified repeatedly against that” (Raymond Saulnier in Hargrove and Morley, 1984,
157).

By the end of the Eisenhower administration, the pattern of coordination for the next decade was in place. Martin held meetings with the president and his advisers, weekly breakfasts or luncheons with the Secretary of the Treasury, and regular meetings with the Council of Economic Advisers. He advised the administration in advance of major changes, for example, by clearing a change in regulation Q with the Secretary on the grounds that it affected the Treasury’s savings bond sales. And the Federal Reserve continued to discuss bond issues with the Treasury, although the FOMC ceased advising the Treasury on what it should sell.

Independence no longer excluded consultations and exchange of information. Martin’s interpretation of the 1951 Accord went further. He, and most others in the System, believed that the Federal Reserve had a responsibility to assure that Treasury bond issues did not fail. He reasoned that Congress voted the budget that the Treasury had to finance. The Federal Reserve had an obligation to help make the issues succeed in the market, provided the Treasury priced its issues at market rates. It should not refuse to accept the fiscal decision or refuse to assist in financing. Help took two forms: preventing failure of new issues and refundings, and maintaining even keel policy during Treasury operations. Even keel meant that the Federal Reserve supplied enough reserves to permit banks to purchase their share of the issue. This seems a narrow meaning of independence. When budget deficits became large and frequent, independence was severely restricted.

Thus, in the 1950s, independence came to mean that the Federal Reserve could raise interest rates as much as its judgment or analysis required to control inflation if private sector demand expanded. But it limited the increase when the Treasury made large demands on the market. It expected, or hoped, that the Treasury would price its offerings consistent with market anticipations, and usually the Treasury did. But if the Treasury erred, the Federal Reserve would help by buying bills and supplying reserves under bills-only and buying the issue if it judged that the market became “disorderly.”
³⁴⁸
Usually, it did not later sell the debt to reduce reserves and money.

Martin borrowed a phrase from Allan Sproul of the New York bank to

348. The minutes suggest that “disorderly” meant that there were few or no bids in the market so that a decline in bond prices induced more supply and additional price decline instead of increasing quantity demanded.

describe the Federal Reserve’s role. It was independent within the administration, not independent of the administration. In practice this meant that it was no less responsible for debt management after the Accord than before. The chief difference was that it was not bound to a specific level of interest rates. It could change rates when the Treasury was not in the market or about to enter. But there were often political pressures coming from the administration and Congress when interest rates rose.

But it is also true that the Keynesian analyses of that period gave a modest role to interest rate changes. This was called “elasticity pessimism”; investment was not expected to respond much to interest rate changes.

Soon a new problem appeared. Commitment to discussion and coordination became more problematic when the administration changed. Officials of the Kennedy and Johnson administrations interpreted coordination as support for their fiscal policies. They wanted to use coordination as a way to influence or control monetary policy. In the 1920s, the Federal Reserve limited international policy coordination to periods and operations that would not cause inflation. It was not able to do the same for domestic coordination in the 1960s.

Faced with these explicit and implicit restrictions, it is not surprising that Federal Reserve officials inveighed against deficit spending. No wonder, then, that they believed, and repeated frequently, that monetary policy
alone
could not prevent inflation. No wonder that the Federal Reserve later failed to prevent inflation. It had sacrificed too much of its independence.

The Federal Reserve was much more concerned about congressional oversight in the 1950s than in the 1920s. For example, it wanted its Annual Reports to show that it responded promptly to rising unemployment, as called for by the Employment Act. It chose the wording of its instructions to the manager with an eye on how they would look when the report appeared. Indeed, the committee at times gave more attention to issues of this kind than to the instruction it gave the manager.

Resumption of policy action reopened old antagonisms. The Board and its staff had been in frequent conflict with the reserve banks, especially New York. In the 1920s, the New York bank, led by Benjamin Strong, dominated decisions. New Deal legislation strengthened the Board’s role and weakened New York’s, but conflict remained.

Martin reshaped the organization, centralizing control in Washington and weakening New York, though it retained its influence and role as fiscal agent of the Treasury. He terminated the FOMC’s Executive Committee, where New York dominated, and he increased the number of FOMC meetings from four a year to sixteen or seventeen, one every three weeks. He
expected all members to participate actively at FOMC and to state opinions. New York’s voice became one among many, although it had more market information and generally spoke before the others. Further, he encouraged, and at times required, discussion of all policy operations, curbing the legal arrangement that put responsibility for proposing discount rates in the reserve banks and responsibility for regulation Q or reserve requirement changes in the Board. The formal structure remained; the operating procedures changed. This, too, weakened the reserve banks by giving the Board a larger voice in discount policy.

The Federal Reserve staff responded rapidly to events in the economy. It recognized quickly the end of expansions and recessions. The FOMC or the Board reversed policy promptly. Although the staff under Riefler did not forecast, their judgments at times proved accurate. As in Brunner and Meltzer (1964), the problem was the reliance on free reserves to judge the policy thrust and the weak relation between changes in free reserves and economic activity or inflation. See also Romer and Romer (1994).

Martin described himself as a “market man.” He had little interest in economic theories or analysis of how the changes that the FOMC initiated reached beyond the money market to prices, employment, or exchange rates. Nor did he form a consistent view of how the Federal Reserve could operate best to achieve its objectives. At times, the Federal Reserve changed the discount rate frequently; at other times, it relied mainly on reserve requirement changes or open market operations. Since both Martin and the FOMC were atheoretical, the Federal Reserve did not have a single measure or set of measures by which it judged what had happened or specified what should happen. Free reserves, borrowing, interest rates, color, tone and feel all had their turn. The connection between these measures and more distant goals remained unclear. Martin made no effort to clarify these issues and was uninterested when others tried. On the other hand, Martin avoided the bad advice that economic models of the period urged on the FOMC.

Martin had long-term objectives. He always favored price stability, the $35 gold price and fixed exchange rates, and well-functioning private markets for Treasury debt that operated with little direct intervention by the Federal Reserve. His problem was not uncertainty about his objectives, it was lack of clarity about how the System’s actions connected (eventually) to those objectives.

Martin was a patient man who encouraged collective decision making. If other FOMC members did not share his view, only rarely did he speak first to tell them what he wanted the FOMC to do. He would often wait several meetings until a majority agreed with him. Similarly, he tried for
several years to get Congress to approve a new Bank Holding Company Act before he succeeded in 1956. He managed also to get Congress to approve counting vault cash as part of required reserves, despite many criticisms of prior reductions in reserve requirement ratios.

The 1950s were the second (after the 1920s) most successful decade that the Federal Reserve had up to that time. Unlike the 1920s, the decade ended with a mild recession, not a major depression. The end of the Korean War brought a recession without postwar deflation. Nevertheless, the Federal Reserve received much criticism, especially criticism from Congress, about three recessions in seven years. Growing balance of payments deficits raised concerns about the “competitiveness” of U.S. industry and the durability of the $35 per ounce gold price.

Martin’s successful revitalization and reorganization of the Federal Reserve notwithstanding, the Federal Reserve carried over into the 1960s three issues that would return many times. First was the balance of payments deficit and the viability of the fixed exchange rate system. The Federal Reserve left international policy to the Treasury. Second, problems with regulation Q ceilings rose and fell with market interest rates. The Federal Reserve had not agreed on how to avoid the monetary effects of shifts of deposits to less regulated institutions, when ceiling rates constrained some member banks. Third, the System had not developed an adequate framework for achieving sustained growth without inflation. These problems began in the 1950s but became more acute after the middle of the next decade.

APPENDIX TO CHAPTER 2

Chart 2A.1 shows the relation between the monetary base and its principal sources and the interrelation of the sources. Estimates come from a fourvariable vector autoregression using the following order: discounts, gold, base, government securities held by the Federal reserve banks. Data are monthly from July 1951 to December 1960. Estimates are based on 2 lags, 11 seasonal dummy variables, and a constant.

The chart offers a statistical analysis of the policy actions discussed in the text. It repeats for the 1950s the relations shown in the appendix to volume 1, chapter 4 for the 1920s. All of the diagonal elements show the same sign and generally the same configuration in both periods. The negative response of gold to government securities and government securities to discounts are the only statistically significant off-diagonal associations that remain the same in the two periods. Open market purchases induced gold outflow; the Federal Reserve offset the brief aggregate effect of discounting by open market operations. Both responses are consistent with interest rate smoothing.

Four signs change. First, the response of the base to gold is negative in the 1950s and positive, after a lag, in the 1920s. The positive response is expected under the 1920s gold standard, although the Federal Reserve did not always follow the rules. Under the Bretton Woods system, the Federal Reserve offset all but a small initial effect of gold on the base. Second, for the same reason, the response of government securities to gold shows that the Federal Reserve completely sterilized gold movements in the 1950s but not in the 1920s. Third, in the 1950s the Federal Reserve changed the base by purchasing government securities to set free reserves. In Chart 2A.1 the monetary base rises in step with the stock of government securities. Fourth, the response of the base to discounts is significantly negative initially in the 1950s and positive in the 1920s. This reflects the manager’s smoothing operations.

The chart shows also that gold outflows followed increases in the monetary base and conversely. Monetary expansion had a significant effect on